The all-conquering exchange-traded fund (ETF) industry has its eyes set on fixed income flows, but professional buyers are far from convinced the vehicle and asset class are a perfect match. Currently ETF assets under management stand at $2.9 trillion in the US, of which only 16% is in bond ETFs, according to Deborah Fuhr, managing partner at research and consultancy firm ETFGI.
Unsurprisingly, those who construct indices or sell ETFs see this as a huge area for growth. Speaking at the ETFGI and Kreab 2017 ETF Trading and Market Structure Conference in June, Thomas Farley, president at the New York Stock Exchange, said: 'I personally think fixed income ETFs, that’s where we are going to look back five years from now, and we are going to say: “Wow we knew there was a wave coming, but we didn’t fully understand or comprehend how big that wave would be.”’
However, if the industry is banking on recommendations from professional buyers then it may want to think again. Citywire spoke to three top gatekeepers, all of whom were skeptical about bond ETFs. In the interests of balance we have also canvassed the views of the Investment Company Institute, which takes a difference stance, rebutting some of the claims around liquidity.
Evan Ratnow – Citi Private Bank, director of fixed income manager research
‘The way fixed income indices are designed is that the most indebted issuers are the ones that have the highest weighting in the indexes. Why would you want to allocate the most money to a country with the most debt?
‘I think smart beta may try to solve that by weighting using a different methodology, like GDP or some other way, not just by outstanding debt, so I guess that could be smart. But I would still much rather pick the manager who cheats their benchmark in the smartest way possible rather than pick an ETF that can’t beat its benchmark.
‘The concept of active ETFs may become more interesting, because I think some clients may appreciate intraday liquidity… so I would be interested in seeing active ETFs in fixed income expand a little bit.
‘There are some active managers who are doing active ETFs. When you ask them what some of the differences are between their active fund and active ETF, it seems like, due to regulatory reasons, the ETFs aren’t able to take some of the same securities at the same measures that the active funds can take.
‘So if its manager A’s active fund versus manager A’s active ETF, I think the active ETF would be more handcuffed.
‘If you have decided you want active management, in my opinion, you don’t want the manager to be handcuffed: you want them to do what they are going to do to generate their alpha and excess returns.’
Rochelle Antoniewicz – Investment Company Institute, senior economist
‘I think there are several things that are wrong with these stories, these assumptions.
‘Bond ETFs have been tested, they’ve been tested in three different stress scenarios.
‘In the summer of 2013, bond ETF trading volumes went up when the Federal Reserve made comments about whether or not they were going to pull back on quantitative easing.
‘The usual sort of doomsday scenario that’s around bond ETFs is this sort of story where we have some external shock to the market that causes everybody to want to sell their ETFs but there are absolutely no buyers out there.
‘That did not happen. Some don’t want to sell, others see it as a buying opportunity.
‘The other big one [stress test scenario], which I thought was key, was December 2015, when you had stress in a very illiquid part of the market, the high yield market.
‘High yield bond ETFs performed exceptionally well that day. By perform, I don’t mean their prices went up. Their prices went down along with the underlying holdings, but then volumes went way up, which meant that for every seller, there was a buyer out there who thought that this was a good opportunity.
‘Again, there were very few redemptions back to the high yield bond funds themselves. If ever there was a time that we were going to see [a lack of buyers] unfold, that was it.
‘The other scenario was most recently – the November election result. We saw treasury yields spike after the election, and yet we saw trading volumes of bond ETFs go up and we saw very little redemptions.
‘So I think we’ve had three pretty good tests, and they’ve performed very well. I’m hoping that this negative narrative out there will start to change.’
Sam McFall – Mill Creek Capital, vice-president, investments
‘Fixed income ETFs concern me because there is a liquidity mismatch between the underlying securities and the ability to trade an ETF intraday. You have underlying securities that, if they needed to be traded quickly, you can’t necessarily do so.
‘I would say maybe the high yield ETFs are probably the most concerning because you could see in late 2015, early 2016, when high yield credit locked up, you could still trade those instruments, but the underlying bonds couldn’t trade easily.
‘I think it could work with treasuries. The most liquid investment grade is probably OK… but when you get into the niche areas of fixed income – whether its emerging market debt, floating rate notes or high yield bonds – it would certainly give me pause for thought and for that reason, we certainly don’t use ETFs there.
‘A lot of the fixed income indices are built so the largest issuers make up the biggest portion of the index, but maybe those aren’t the best credits. We tend to prefer active management within the fixed income area. We do occasionally use an investment grade placeholder ETF, but by and large we don’t view it as a long-term vehicle.
James St. Aubin – Highmark Capital Management, managing director
‘There are certainly inefficiencies in the [bond] market, which is why you see active managers perform so well relative to benchmarks in the fixed income space, especially in the core sector.
‘I think that there’s definitely room for benchmark-beating ETF strategies if they can be systematic and low cost at the same time – we’re certainly going to pursue that.
‘They could come up with something that’s cost efficient, but the academic research has been focused more on the equity side and not as heavily looked at on the fixed income side.
‘For us to get more comfortable with that, we would need to study the ways in which they would try to pursue inefficiencies. I think there are certainly inefficiencies within fixed income benchmarks, even more so than cap-weighted equity benchmarks.
‘One thing we understand is that ETFs can have certain hidden costs like the bid/ask spread and premiums and discounts related to those offerings.
‘If I feel like there is a comparable mutual fund that delivers what I’m looking for, say Pimco Total Return or the DoubleLine Total Return funds, I would probably gravitate more to the mutual fund because it gives me more certainty as to what I’m paying for that investment opportunity.
‘What we have to consider is that liquidity in the fixed income market isn’t quite as strong, and transaction costs within creation and redemption units are remarkably different, so that can have an impact on performance as well.
‘That being said, if you’re offering the same thing in a different wrapper that would get our attention. If it’s truly identical, we are going to go with the cheaper version, but they aren’t always truly identical. If you look at DoubleLine’s fund, there are some differences in regards to what they can buy and their liquidity, so it’s not a mirror image of the mutual fund, and that’s something to consider.’